How Businesses Create Wealth
By UWE E. REINHARDT
Uwe E. Reinhardt is an economics professor at Princeton.
In last week’s post I offered a near metaphysical definition of wealth that set off a lively round of commentaries.
This week I explore how companies create “value” and distribute it among various stakeholders.
That value can be consumed on the spot to produce other goods and services or to create a consumer’s well-being. Alternatively, it can be saved and stored in the form of some asset. Freshman economics texts define an economic unit’s wealth as the market value of all of its assets minus its liabilities. Value creation and wealth are thus related.
Let’s imagine a company called ABC Inc., which produces a standard, ordinary commodity, by which I mean that society does not hold particular ethical strictures on its distribution (as we, for example, do for health care and education). The chart below sketches the value flow caused by the production of some volume of output. (The pipes going in and out of the company are not drawn to scale.)
Uwe E. Reinhardt
The large pipe in the upper left corner labeled “Gross Value Created” represents the maximum revenue ABC Inc. could have extracted from its customers if each unit of output could have been auctioned off, one after the other, to the highest bidder — an arrangement economists call “perfect price discrimination.” This hypothetical, maximum extractable revenue is the economist’s measure of the “social value” of ABC Inc.’s output.
Evidently, by thus defining social value, economists tacitly assume that rich people, who can bid a higher price for a thing, “value” the thing more than do poor people, even though rich people may not crave it any more than do poor people and possibly even less. It often surprises students that modern economics is solidly based on that legerdemain, which I admit to them in a memo entitled: “How We Economists Bastardized Benthamite Utilitarianism and Became Shills for the Wealthy.”
Leaving aside this important fine point, the sketch is drawn to show that ABC is not able to capture in the form of “sales revenue” all of the gross value it creates.
This is because in most markets, output is sold at a single, common price to all customers, which allows many of them to obtain units of the output at market prices below the maximum bid prices they would have offered in our hypothetical auction. The difference between the two prices is called “buyers’ surplus.” It is a kind of intangible profit that sellers must cede to buyers.
ABC Inc. now distributes the value it captures as “sales revenue” to sundry stakeholders as follows.
Usually the largest fraction is allocated to employees in the form of “employee compensation.” For most employees, the gross value they extract from the corporation as compensation exceeds their so-called “reservation wage.” The latter is the minimum compensation they would have to be paid to attract them to and retain them in the corporation.
This “reservation wage,” of course, is strongly influenced by what the employee could earn in the next best employ — the employee’s “opportunity costs” of working for ABC Inc. — but it also is influenced by how much employees like working there.
The difference between an employee’s actual compensation and his or her reservation wage is the net value employees extract from the corporation. Economists view it as a form of profit, too.
Indeed, it may astound union leaders that many companies bestow more profits of this type on their employees than they bestow profits on their shareholders. It almost surely is so in heavily unionized industries — e.g., the automobile or transportation industries. But it can easily be true even in non-unionized industries.
Brushing lightly over the fraction of ABC’s sales revenue (which is captured gross value) that flows to creditors in the form of interest, to suppliers of non-labor inputs, and to government in the form of taxes, we arrive at a residual that accrues to the owners as “profit available for distribution to shareholders.”
Management and the company’s directors may decide to distribute some of that residual to shareholders in the form of cash dividends. But usually the bulk or even all of it is plowed back into the company in the form of “retained earnings.” Few shareholders take out much of the gross value their companies create in the form of cash.
Wall Street bases its estimate of the company’s “market capitalization” solely on the residual “profit available for shareholders” pipe, eclipsing from view the entire value-flow that accrues to other stakeholders. Unfortunately, many journalists and pundits in the financial press then mistake that “market capitalization” as the sole measure of the “wealth” the company creates, not realizing that this metric can rise or fall for reasons other then genuine value creation by the company.
Suppose, for example, that a company’s volume of output has not changed, but that it somehow manages to raise prices paid by some or all buyers, capturing more of an unchanged gross value created by the company’s output. The company’s market capitalization would be likely to rise as a result of the price increase. But would that add to the nation’s stock of wealth? Or would it merely be a redistribution of wealth from buyers to shareholders?
Similarly, suppose new management takes over and changes nothing other than reducing or eliminating retiree health benefits promised to already retired workers during their working years, albeit in a contract that can be broken (as many such contracts can be broken). If those savings in expenses then flow through to the owners’ profits, the company’s market capitalization would be likely to increase. But is that an increase in national wealth?
I would argue that a corporation contributes to national wealth only if it does something to increase the “total gross value” of what it produces. Someone will then get that added gross value — the buyers in the form of buyers’ surplus or employees in the form of added compensation (perhaps mainly executive bonuses) or the shareholders, and so on.
Regardless of its distribution among stakeholders, and even if none of it flows to the company’s owners, that added gross value can be viewed an addition to national wealth, at least at that moment, before it may be burned up in production elsewhere or on consumption.
http://economix.blogs.nytimes.com/2010/05/07/how-businesses-create-wealth/
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